Emerging Markets

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The tensions between Russia and the West over Ukraine are boiling over, as the risk of a conflict escalates. Following Washington’s written response to Moscow’s demands, BCA’s Geopolitical Strategy team now assigns a 75% probability to a Russian invasion of its neighbor. Matt Gertken, the team’s Chief Strategist, sees only a 10% chance that Russia will aim to conquer the whole of Ukraine. European markets are vulnerable to a Russian retaliation, and so we recommend hedging exposure to Europe and cyclical assets until the situation clears up. The euro remains at risk as long as tensions fester. Who Is Most Vulnerable To A Russian Energy Embargo? Protection Needed Protection Needed Bottom Line: Buy hedges such as short EUR/JPY and short EUR/CHF to protect portfolios against the risk of a conflict in Ukraine. The euro has more downside from here. Feature Handicapping The Risk Of War On Wednesday, after weeks of tense discussions, the US sent back its formal written response to Russia’s demands. Upon analysis of the situation, our geopolitical team concluded that the Biden administration offered no significant concessions. The US will not stop providing weapons to Ukraine, which, from Russia’s perspective, implies that its largest occidental neighbor could become “Russia’s Taiwan, i.e. a foreign-backed military enemy on its door step.”  Matt Gertken, BCA’s Geopolitical Strategy team’s Chief Strategist, believes that the probability of a diplomatic solution has fallen to 25%, despite the joint statement made by Russia, Ukraine, France, and Germany on January 26, which reaffirms the ceasefire in the Donbass region of Ukraine. Any minor violation of the ceasefire’s terms by Ukraine will create an excuse for a Russian invasion. The nature of the eventual conflict will be crucial to the economic and market outlook for Europe. Matt argues that Europeans are hamstrung by their large dependence on Russian energy. Even switching to US LNG in case of a crisis this winter will not fill the full gap and cause major economic distress in Europe. As a result, European governments will try to avoid a war in order to limit sanctions so that Russia does not cut energy supply further. However, Europeans are also allied with the US, which will push for sanctions and which is not as afraid of the consequences of a conflict. Faced with this dichotomy, Matt argues that the most likely outcome is that Russia will ultimately concentrate on the Eastern Ukraine. He observes that “Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus, Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession.” In terms of the breakdown of probabilities, he sees a 65% probability of a short conflict whereby the battle is to control Eastern Ukraine, a 10% probability of a Russian effort to conquer the entire country, and a 25% probability of a diplomatic solution. According to Matt, it is too soon to buy the dip. Even if the situation on the ground matches our base case scenario of a limited conflict, Russia will employ a shock-and-awe strategy, creating the first major conflict on European soil since World War II. This will surprise investors and cause a knee-jerk spike in European energy prices. It will produce downside in the euro and in the relative performance of European equities, especially as it could take a few weeks before it becomes clear whether Russian troops will permanently cross the Dnieper. Bottom Line: European markets should brace for some volatility caused by Ukrainian events in the coming weeks. BCA’s geopolitical strategy team assigns only a 25% probability to a diplomatic resolution to the current tensions, a 65% probability to a limited Russian incursion in Ukraine, and a 10% chance of a war for the entire Ukrainian nation. Economic Risks Chart 1A Large Energy Shock For A Recession Protection Needed Protection Needed The economic implications of our base case scenario – a limited conflict – are restricted. As we showed three months ago, energy consumption only represents roughly 2% of European GDP. It would require a durable shock associated with a drawn-out conflict – the 10% probability scenario – to push up this ratio to the levels reached before the GFC, when energy prices were squeezing Europe (Chart 1). Nonetheless, markets will price in this probability as the conflict starts. Thus, understanding which economy is more vulnerable will help assess the risks to the market. The first metric to gauge vulnerability is the role of fossil fuels in the energy mix of European countries. In the event that a conflict causes an increase in energy prices, countries that rely more heavily on fossil fuel will experience a greater shock. On this front, pre-pandemic data from Eurostat shows that the Netherlands, Ireland, Poland, Greece, and Germany are the most exposed nations (Chart 2). By contrast, Sweden, Finland, France, and Denmark are the least exposed as a result of the role of nuclear or wind power generation in these countries. Chart 2Who depends Most On Fossil Fuel? Protection Needed Protection Needed Another metric is the share of a nation’s energy needs fulfilled by imports (Chart 3). On this score, Belgium, Italy, Spain, Greece, and Portugal are the most vulnerable nations, whereas Sweden, the UK, Denmark, and Czechia are the least at risk. Chart 3Who Depends Most On Imported Energy? Protection Needed Protection Needed We can also concentrate on the impact of the risk of a Russian embargo on energy shipments to Western Europe. Chart 4 shows that, when it comes to crude oil, Finland, Poland, Hungary, and, to a lesser extent, Czechia are most vulnerable, whereas Austria, Spain, and Ireland are the least at risk. With respect to natural gas, which is crucial to electricity generation, Czechia, Finland, and Hungary are the three most vulnerable countries, whereas Sweden, Austria, Ireland, and Denmark are not (Chart 5). Chart 4Who Depends Most On Russian Oil? Protection Needed Protection Needed Chart 5Who Depends Most On Russian Natural Gas? Protection Needed Protection Needed We may also combine all these measures and approximate the share of the total energy needs of European countries fulfilled by Russia. Our Vulnerability Index shows that the most exposed nation is by far Hungary, followed by Poland, Germany, Czechia, and Italy (Chart 6). This ranking helps explain why the German government’s support for Ukraine remains somewhat tepid, and why Italian businessmen still held a video call with Russian president Vladimir Putin as recently as last Wednesday. Chart 6Who Is Most Vulnerable To A Russian Energy Embargo? Protection Needed Protection Needed Bottom Line: Hungary, Poland, Germany, Czechia, and Italy are the European nations most exposed to an energy crisis in the event of a drawn-out, all-out war in Ukraine, whereas Austria, Sweden, Denmark, Ireland, and the UK are the least exposed. This scenario carries only a 10% probability, but understanding its impact is important, since investors will have to adjust their expectations once a conflict begins in the Ukraine. The ECB Response The ECB response to a Ukrainian conflict will depend on the nature of the war. In our base case scenario involving a limited assault focused on Eastern Ukraine, the ECB will look at any energy shock and its impact on inflation as temporary. European wage gains remain limited (Chart 7), and the Governing Council will assume that any spike in energy prices will not last long enough to dislodge European inflation expectations. This picture will be very different if Russia tries to conquer Western Ukraine as well. While the potential energy embargo will most likely cause a European recession, it will also risk pushing up inflation expectations permanently. Because expectations are already close to the ECB’s objective (Chart 8), the ECB will respond by tightening policy, which many members of the GC will want. This action is likely to accentuate any recessionary pressures in Europe. Again, we cannot stress enough that this constitutes a tail risk and is not our base case scenario. Chart 7European Wage Growth Remains Tame European Wage Growth Remains Tame European Wage Growth Remains Tame Chart 8Inflation Expectations Could Become Unmoored Inflation Expectations Could Become Unmoored Inflation Expectations Could Become Unmoored Market Implications The Euro Three weeks ago, we wrote that the euro was not ready to bottom because the risks associated with a slowing Chinese economy, the continued economic impact of Omicron, and the volatility of the natural gas market were still too considerable. Chart 9Another Wave Of Euro Selling Another Wave Of Euro Selling Another Wave Of Euro Selling This is even more true after last week’s Fed press conference, when FOMC Chair Jerome Powell did not contest the aggressive market pricing in the OIS curve. As a result, the window remains open in the near-term for interest rate differentials to move in a euro-bearish fashion (Chart 9). Ukraine adds another near-term threat to the euro. First, the run-up to an invasion, whether total or partial, will create a risk-off wave in global markets. Geopolitically driven sell-offs are most often associated with a rise in the counter-cyclical dollar, which is euro-bearish. The Swiss franc too would benefit against the euro. Moreover, Europe is much more exposed than the US to the economic consequences of a Ukrainian crisis. Obviously, our base case scenario implies a shorter and shallower sell-off than what would happen if Russia tried to conquer the whole of Ukraine. Nonetheless, a move below EUR/USD 1.10 now carries a greater than 40% probability. Bunds In our base case scenario of a limited Russian incursion in Ukraine, we should see a temporary dip in German yields driven by risk aversion. However, larger economic forces continue to point toward higher yields around the world, including in Germany. In our tail risk scenario, the German yield curve is likely to invert. ECB rate hikes will not be enough to push up 10-year yields, as markets will reflect that these increases will be temporary because of the associated recession. Instead, German 10-year yields will regress toward their 2021 lows of -0.55%. Equities Chart 10European Stocks Are Now Cheap European Stocks Are Now Cheap European Stocks Are Now Cheap Since mid-December, European equities have been outperforming US equities on the back of rising yields. We expect European shares to continue to outperform US stocks over the remainder of the year. As we wrote two weeks ago, European stocks possess a more generous valuation cushion against higher yields than their US counterparts, especially now that forward multiples have fallen back to 15.4, their lowest levels since May 2020 (Chart 10). Moreover, the greater cyclicality of European stocks means that they will benefit from an eventual stabilization of the Chinese economy by the latter half of 2022. They also stand to gain from a gradual normalization of the terminal rate proxy over the coming years, which often coincides with an outperformance of value stocks over growth names. Despite this positive outlook, the Ukrainian crisis poses a considerable near-term risk, even in the base case scenario of a limited Russian military aim. The wave of risk aversion will hurt the euro, which arithmetically will weigh on the relative performance of European stocks in common currency terms. Moreover, the more pro-cyclical profile of European stocks will accentuate their vulnerability in a geopolitical crisis. However, the temporary nature of the risk-off wave means that the woes suffered by Europe will also be transitory. Under the tail risk scenario, European equities will not be capable of outperforming those of the US for many months because of the high recession risk that will engulf the region. High energy prices will destroy the profit margins of European companies, which will already suffer from a hit to their top line-growth. US equities will suffer too, but significantly less so. Chart 11European Cyclicals Are Exposed To A Crisis In Ukraine European Cyclicals Are Exposed To A Crisis In Ukraine European Cyclicals Are Exposed To A Crisis In Ukraine Sector wise, a Ukrainian crisis will also short circuit the outperformance of European cyclicals over defensive equities. For now, European cyclicals have managed to generate alpha, despite the market correction (Chart 11), but the risk of a recession will affect this trend. Under our base case scenario, the underperformance will be short-lived, even if it proves severe; however, under the tail risk scenario, the cyclicals-to-defensives ratio will plunge toward the bottom of its historical range. Within defensive sectors, utilities will likely underperform, especially if the tail risk scenario comes to fruition. European governments will not allow utilities to pass on the full increase in natural gas prices to consumers, which will create a major compression in utilities’ profit margins. For cyclical names, consumer discretionary will bear the brunt of any sell-off. They are relatively pricey and the combination of the potential shock to household disposable income and rising risk aversion will prove to be lethal. The sales and profit margins of industrials will be under stress. However, this shock will be transitory if the Ukrainian crisis remains contained in our base-case scenario. Chart 12The Russian Exposure Of European Banks Protection Needed Protection Needed Financials carry their own risk in the context of a drawn-out Ukrainian crisis. European banks have exposure to Russia equal to $106 billion, concentrated in France and Switzerland (Chart 12). In and of itself, this is small. However, if European nations impose large enough sanctions on Russia, not only will that country cut its energy shipments to Western Europe, but Russian firms will also likely default on their foreign obligations, emboldened by Russia’s robust FX reserves and balance of payments. In the context of a recession wherein the ECB also hikes rates, these defaults will add considerable stress to the European banking sector. Thus, under our tail risk scenario, financials could perform particularly poorly. In terms of the implications for countries, Germany is the most exposed of all the major European markets to a Ukrainian crisis because of its high energy dependence on Russia and fossil fuels. The recent underperformance of German equities when we correct for sectoral bias probably already reflects the recent rise in electricity costs in the country, which hurt German firms versus their European competitors (Chart 13). While we like the fundamentals of European small-cap stocks, we have remained on the sidelines because of the strong correlation between their relative performance and the trade-weighted euro (Chart 14). The risks surrounding Ukraine and their implications for both the euro and the European economy suggest it is still too dangerous to pull the trigger and overweight small-cap in Europe. However, if our base case scenario of a limited conflict comes true, then this will create the perfect opportunity to move into the European small-cap space. Chart 13German Suffers A Nat Gas Discount German Suffers A Nat Gas Discount German Suffers A Nat Gas Discount Chart 14Small-Caps Need A Euro Bottom Small-Caps Need A Euro Bottom Small-Caps Need A Euro Bottom Investment Implications Considering the probability distribution laid out by BCA’s Geopolitical Strategy team, whose base case scenario is a limited Russian incursion into Ukraine, we do not expect NATO countries to impose sanctions severe enough to force Russia to cut Western Europe’s energy supply. Nonetheless, the prospect of the most significant military conflict on European soil since World War II will have a significant impact on European asset prices, even if this effect is transitory. As a result, we still maintain our preference for cyclical equities in Europe and still expect European equities to outperform US stocks over the course of 2022. We also continue to anticipate that European stocks will outperform Bunds in 2022. Nonetheless, ahead of the conflict, we recommend investors buy some hedges, such as short EUR/CHF and EUR/JPY to protect against downside risk. Rapidly after the conflict begins, an opportunity to close those hedges will emerge. With respect to the euro, the combined stress from a hawkish Fed and Ukrainian risks means we will stay on the sidelines after having been stopped out of our long EUR/USD trade. If our base case of a limited conflict does come to fruition and Russia instead initiates a full invasion of Ukraine, we will shift our portfolio to a fully defensive stance. The euro could re-test parity or even drop below it.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover A Correction Not A Bear Market A Correction Not A Bear Market Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Business Cycles Drive Earnings Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive US Homebuilders Looking Attractive US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix A Correction Not A Bear Market A Correction Not A Bear Market Special Trade Recommendations Current MacroQuant Model Scores A Correction Not A Bear Market A Correction Not A Bear Market

Highlights The faster-than-expected oil-demand recovery from the COVID-19 omicron variant points to higher EM trade volumes this year and next, which, along with a weaker USD, will boost base-metals demand and prices (Chart of the Week). The recovery in iron-ore prices on the back of China stimulus and omicron-induced labor shortages at miners will lift copper prices, the base-metals' bellwether.  Supply-demand balances in refined copper showed a physical deficit of 438K MT for the January-October 2021 period, indicating the market extended its years-long deficit in 2021. Despite the IMF's mark-down in global growth due to slowdowns in the US and China this year, metals demand will continue to exceed supply, which will support prices. Short squeezes – most recently in nickel, following a headline-grabbing copper squeeze in October – will keep base metals' inventories under pressure and forward curves backwardated. We remain long the S&P GSCI and the COMT ETF, as well as the PICK ETF, to remain exposed to backwardation.  At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off. We are raising our 2022 copper target to $5.00/lb on COMEX, and keeping our 2023 expectation at $6.00/lb. Feature Inadequate development in new base metals supply, which has been apparent for years, means economic recovery and expansion will continue to tax existing supplies over the short run (to end-2023).1  Chart of the WeekExpected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Expected Global Trade Pick-Up Will Boost Base Metals Demand Chart 2Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... Physical Deficits Will Persists In Copper... At a global level, prolonged supply-demand imbalances mean inventories will continue to be drawn hard to cover for prompt supply shortfalls.  This can be seen in the principal base metals we cover: copper (Chart 2), aluminum (Chart 3), nickel (Chart 4), and zinc (Chart 5).  As a result, short squeezes in base metals markets will continue to grab headlines, as persistent physical deficits periodically drain inventories.2   Longer term, the global effort to decarbonize energy supply could be stretched out well beyond 2050, when most policymakers assume the task of replacing fossil-fuel energy sources will largely be completed.  The longer it takes to mobilize capex, the more expensive the energy transition becomes, as markets are continually forced to adjust to short-term shortages leading to price spikes and squeezes in an effort to meet demand. Chart 3...Aluminum... ...Aluminum... ...Aluminum... Chart 4...Nickel... ...Nickel... ...Nickel... Chart 5...And Zinc. ...And Zinc. ...And Zinc. Faster Demand Recovery In Metals Faster-than-expected oil-demand recovery will translate to higher trade volumes globally this year and next.  This is particularly important for EM markets, given oil and metals prices – particularly copper, the base metals bellwether – share a common long-term equilibrium (i.e., they're cointegrated, as seen in the Chart of the Week).3 A pick-up in EM trade volumes, along with a weakening USD this year, will help lift copper prices.  Most trade is in manufactured goods, which will translate into a pick-up in cyclical stocks vs. defensive stocks as well, which also is supportive of copper prices (Chart 6). Copper prices also will be supported by the recovery in iron-ore prices, which have been bid up on the back of increasing stimulus in China and global growth ex-China, as well as omicron-induced labor shortages among miners.  As is typical, copper demand will follow in the wake of steel demand, as construction and infrastructure projects are finished off (i.e., plumbing and wiring are installed) (Chart 7). Chart 6Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Global Trade Recovery Will Boost Copper Chart 7Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Iron Ore Rally Will Boost Copper Supply Side Remains Challenged Impressive gains put up on the supply side last year in Indonesia – which, according to the International Copper Study Group, posted a 51% increase in copper output at the Grasberg mine over the first 10 months of 2021, – and other smaller producers notwithstanding, geopolitical uncertainty continues to dominate the supply-side risks to base metals generally, copper in particular.4 Economic and political uncertainty in Chile and Peru, which account for 30% and 10% of global copper output, respectively, will continue to keep miners hesitant in their capex allocations, in our view.  Both states have elected left-of-center governments, which still are working through how they will deliver on their election mandates, including revenue re-distribution, taxation and royalties.5 The combination of stronger demand and tepid supply growth will keep base metals inventories under pressure, which will translate into continued backwardation.  This is particularly apparent in the copper (Chart 8) and nickel (Chart 9).  Both of these squeezes resulted from buyers treating the London Metal Exchange as a supplier of last resort – which is an extremely rare occurrence in futures markets – and both required the intervention of the London Metal Exchange to address.6 Chart 8Copper Backwardation Will Persist Copper Backwardation Will Persist Copper Backwardation Will Persist Chart 9...As Will Nickels ...As Will Nickels ...As Will Nickels Investment Implications Base metals markets will continue to find it difficult to match supply with demand, as they have for the past several years.  This further compounds the global energy transition – largely because the suppliers of the metals needed to pull it off are starting from a deep physical deficit position – and likely delays it considerably. In an environment in which obstacles to developing the supply needed to phase out fossil fuels in favor of renewable generation continue to mount, we remain long commodity index exposure – the S&P GSCI and COMT ETF – and favor exposure to miners and trading companies that are responsible for moving metals around the globe. At tonight's close, we are getting long the SPDR S&P Metals and Mining ETF (XME) ETF, following its recent sell-off of 10% for its highs of $47/share.  Our view on base metals is they are a long-term value play, in which miners and the supply side generally, will benefit from the high prices needed to develop the supply the energy transition will require.  The big risk here is these companies once again lose the plot and fail to control costs to produce at the expense of the health of their margins.  If we see this, we will exit the position.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish We expect OPEC 2.0 to announce they'll continue with the return of another 400k b/d at next week's monthly meeting.  In reality, the producer coalition most likely will fail to return these volumes to market and will fall short of the mark again.  The real news markets are waiting for is whether the four states capable of increasing supply and sustaining higher output – Saudi Arabia, Iraq, the UAE and Kuwait – will step up to cover the growing gap between volumes that were pledged and what's actually been delivered.  The coalition agreed in July 2021 to begin returning some of the 5.8mm b/d of output pulled from the market during the COVID-19 pandemic starting in August 2021.  To date, the producer group has fallen short by about 800k b/d, based on the IEA's January 2022 estimates. Failure to increase production by the four core OPEC 2.0 states could keep prices above $90/bbl this year and next (Chart 10). Base Metals: Bullish Iron ore prices have rallied ~ 14% since the start of this year, as markets expect China to ease steel production cuts in 2022 and loosen monetary policy.  Last week, the People’s Bank of China (PBoC) cut its policy interest rate for the first time in nearly two years.  Markets expect more stimulus and policy easing in China as the central bank and government attempt to stimulate an economy mired by COVID-19 lockdowns, a property market slump and high energy prices.  Higher stimulus implies more commodity refining and manufacturing activity, including steel production, which will lead to higher iron ore demand. Precious Metals: Bullish In line with market expectations, the Federal Reserve signaled an initial rate hike in March, in its January Federal Open Market Committee (FOMC) meeting. While nominal interest rates will rise, the Fed will remain behind the inflation curve. The US CPI reading for December showed that inflation was 7% higher year-on-year, the highest annual increase in inflation since 1982 (Chart 11). High inflation and the Fed’s slow start to raise nominal interest rates will keep real rates, the opportunity cost of holding gold, low. Chart 10 Brent Forecast Restored To $80/bbl For 2022 Brent Forecast Restored To $80/bbl For 2022 Chart 11 Short Squeezes In Copper, Nickel Highlight Tight Metals Markets Short Squeezes In Copper, Nickel Highlight Tight Metals Markets     Footnotes 1     Please see 2022 Key Views: Past As Prelude For Commodities, published on December 16, 2021 for additional discussion. 2     Please see Column: Nickel gripped by ferocious squeeze as stocks disappear: Andy Home, published by reuters.com on January 20, 2022; and LME copper spreads backwardated amid stock squeeze, published by argusmedia.com on October 20, 2021. 3    This was flagged most recently in the IEA's January 2022 Oil Market Report, which noted, "While the number of Omicron cases is surging worldwide, oil demand defied expectations in 4Q21, rising by 1.1 mb/d to 99 mb/d. In 1Q22, demand is set for a seasonal decline, exacerbated by more teleworking and less air travel. We have raised our global demand estimates by 200 kb/d for 2021 and 2022 – resulting in growth of 5.5 mb/d and 3.3 mb/d, respectively – due to softer Covid restrictions."  Please see Higher Output Needed To Constrain Oil Prices for our latest oil balances and price forecasts.  We published this report last week. 4    Please see International Copper Study Group press release of January 2022. 5    Please see Add Local Politics To Copper Supply Risks, which we published on November 25, 2021, for a discussion of these risks. 6    Please see Footnote 2 above.     Investment Views and Themes Recommendations Strategic Recommendations Trades Closed In 2021 Image

Feature Is the worst over for US and EM equities? Clearly, the risk-reward of stocks has somewhat improved, given they are no longer overbought and some bad news has already been priced in. However, conditions for a durable bottom and a sustainable and lasting rally do not yet exist. In the case of the S&P 500, our capitulation indicator has not yet reached the lows that marked the major bottoms of the past 12 years (Chart 1). Chart 1US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 2Components Of US Equity Capitulation Indicator Components Of US Equity Capitulation Indicator Components Of US Equity Capitulation Indicator None of its four components – the advance/decline line, momentum, breadth and investor sentiment – are back to their lows of 2010, 2011, 2015-16 and 2018 (Chart 2). In the past three cases, the S&P 500 corrected by 17-20%. A correction of this magnitude is our base case for the S&P 500 at the moment. The S&P drawdown has so far been half of this. US inflation and the Fed’s policy remain the key headwinds to US share prices. Core consumer price inflation is substantially above the Fed’s preferred range (2-2.25%) and wage growth is accelerating. As a result, the Fed will lose credibility if it does not sound ready to hike interest rates materially. The US equity market is vulnerable to such a not-dovish stance from the Fed because it is still very expensive. Inflation has also become a political problem. One reason Biden’s popularity has been sliding in the polls is the rapid pace of consumer price increases. Heading into the mid-term elections in the fall, the White House and the Democrats will not oppose the Fed raising interest rates to fight inflation. Overall, BCA’s Emerging Markets Strategy team believes markets/investors are underestimating inflation risks in the US. Core inflation will not drop below 3% unless the economy slows down and employment/wages slump. High and rising trimmed-mean and median CPI measures suggest inflation is broad-based. Normalization in supply-side factors will not be enough to lower core inflation below 3%. Importantly, the median and trimmed-mean core inflation measures strip out goods and services that post abnormal fluctuations. Their elevated readings corroborate that inflation is genuine and broad-based. Hence, pressure on the Fed to tighten will remain substantial. This is bad news for a still overvalued US stock market. Chart 3EM EPS Is Set To Dissapoint EM EPS Is Set To Dissapoint EM EPS Is Set To Dissapoint Concerning EM equities and currencies, economic growth in EM will disappoint. Chart 3 suggests that EM corporate profits are set to deteriorate materially in the coming six months or so. Besides, investor sentiment on EM equities is not downbeat – it is neutral (Chart 28 below). From a contrarian perspective, there is not yet a case to buy EM stocks in absolute terms. China’s business cycle recovery is still several months away. In other EM countries, monetary policy has tightened substantially, real interest rates remain high, or the banking system is too unhealthy to support growth. Finally, fiscal policy will be slightly tight this year in the majority of EM. As domestic demand in China and in mainstream EMs disappoint and the Fed does not do a dovish pivot soon, EM currencies will resume their depreciation versus the US dollar. Chart 4 shows that China’s credit and fiscal impulse leads EM currency cycles and is presently pointing to more EM currency depreciation. Charts 32 and 33 (below) are pointing to further greenback strength. Finally, EM growth disappointments and a strong greenback will pressure EM fixed income markets. EM high-yield (HY) credit – both sovereign and corporate – has been selling off, but investment-grade (IG) credit has been holding up (Chart 5). This is a sign that investors have been reluctant to offload EM IG credit and points to lingering positive sentiment on EM and lack of capitulation. Sluggish EM growth and an appreciating US dollar are headwinds for EM credit markets. Chart 4EM Currencies Remain At Risk EM Currencies Remain At Risk EM Currencies Remain At Risk Chart 5EM Credit Markets: The Selloff Will Broaden EM Credit Markets: The Selloff Will Broaden EM Credit Markets: The Selloff Will Broaden Bottom Line: We continue to recommend a defensive strategy for absolute return investors. For global equity portfolios, we recommend underweighting EM and the US, and overweighting Europe and Japan. The path of least resistance for the US dollar is up for now. The charts on the following pages are the most important ones for investors today. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Stocks Have Not Reached Their Selling Climax Yet Even though only 17% of the NASDAQ’s stocks are above their 200-day moving average, the same measure for the NYSE index is 38%, well above its previous lows. Besides, the NYSE’s advance/decline line has broken down, signifying a broadening equity rout. Finally, the US median stock has broken below its 200-day moving average after going sideways for 9-12 months. When such a profile occurs, the sell-off lasts more than a couple of weeks. Chart 6 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 7 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 8 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 9 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Non-US Stocks Are Not Oversold Yet Neither global ex-US nor EM stocks are very oversold. Global ex-US and European share prices in SDR terms have been moving sideways for about 9-12 months prior to breaking down recently. Such a breakdown means a weakness in share prices that will likely last for a while. Chart 10 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 11 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 12 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 13 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Growth Stocks Have Broken Down Various indexes of growth/TMT stocks have broken below their moving averages that have served as a support since spring 2020. This along with the fact that US interest rates will likely rise suggests that the bull market in growth stocks is either over or in for a prolonged hibernation. Chart 14 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 15 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 16 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 17 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Is FAANGM A Bubble? In the past 12 years, US FAANGM stocks rose as much as the previous bubbles. When those bubbles peaked, their prices did not move sideways but rather collapsed. We do not assert that US FAANGM stocks will drop by more than 35% (we simply do not know). The point we would like to emphasize is that the bull market is over for now. At best, US growth stocks will likely be in a trading range in the coming 12-24 months.  Chart 18 Is FAANGM A Bubble? Is FAANGM A Bubble? Chart 19 Is FAANGM A Bubble? Is FAANGM A Bubble? US Share Prices And Corporate Margins: Defying Gravity? From a very long-term perspective, the US equity market is rather overextended. Share prices in real terms are almost two standard deviations above their time trend. Similarly, corporate profits in real terms are also very elevated, not least in their reflection of record-high profit margins. The key questions for US equity investors are: (1) how persistent/sticky core inflation will be; and (2) how low corporate profit margins will drop. Wages are the key to both inflation and corporate margins. We believe wage growth will accelerate materially. That will be bad for the outlook of inflation and corporate profit margins, although it will be good news for corporate top lines. Chart 20 US Share Prices And Corporate Margins: Defying Gravity? US Share Prices And Corporate Margins: Defying Gravity? Chart 21 US Share Prices And Corporate Margins: Defying Gravity? US Share Prices And Corporate Margins: Defying Gravity? The Levels of EM Share Prices And Corporate Profits Have Been Flat For 12 years Contrary to the US, EM share prices are not overextended – they have been flat in absolute terms for the past 12 years. The reason for such dismal performance has been stagnant corporate profits. The latter have been flat-to-down in real terms for the past 12-14 years. A breakout in EM share prices in absolute terms will require their EPS entering a secular uptrend. While this is not impossible this decade, it is not imminent. Chart 22 The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years Chart 23 The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Based on a cyclically-adjusted P/E (CAPE) ratio, EM stocks are close to their fair value. In contrast, based on the same measure, US equities are very overvalued. As a result, the relative CAPE ratio of EM versus the US is at a record low. Hence, on a multi-year horizon, odds are that EM share prices will outperform their US peers. In a nutshell, EM ex-China, Korea, Taiwan currencies are also close to their fair value. We will be looking to upgrade EM in the coming months. Chart 24 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 25 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 26 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 27 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Investors Are Not Bearish On EM And Europe One missing factor to upgrade EM (non-US markets in general) is investor sentiment. Sentiment is neutral on EM stocks and is fairly upbeat on Europe. In brief, a capitulation has also not yet occurred in non-US markets. On the whole, the current EM sell-off will likely linger until sentiment becomes downbeat. Chart 28 Investors Are Not Bearish On EM And Europe Investors Are Not Bearish On EM And Europe Chart 29 Investors Are Not Bearish On EM And Europe Investors Are Not Bearish On EM And Europe Directional Indicators For EM Stocks Points To More Downside The cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) moves in tandem with EM share prices. The same holds for the NZD versus the USD. The rationale is as follows: all of these currencies correlate with the global business cycle and global risk-on/off trends. Presently, the SEK/CHF cross and the NZD point to lower EM share prices. Chart 30 Directional Indicators For EM Stocks Points To More Downside Directional Indicators For EM Stocks Points To More Downside Chart 31 Directional Indicators For EM Stocks Points To More Downside Directional Indicators For EM Stocks Points To More Downside The US Dollar Is To Rally Further The Fed’s willingness (for now) to hike rates is positive for the greenback. The trend in relative TIPS yields between the US and Germany heralds further USD strength against the euro. Also, the cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) entails more upside in the broad trade-weighted US dollar. Chart 32 The US Dollar Is To Rally Further The US Dollar Is To Rally Further Chart 33 The US Dollar Is To Rally Further The US Dollar Is To Rally Further Worrisome Market Profiles Several markets such as EM non-TMT share prices, Korean tech stocks, the Chinese onshore CSI300 stock index and silver prices have all failed to break above their 200-day moving averages and are now relapsing. Such a profile is often consistent with new cyclical lows in these markets. Chart 34 Worrisome Market Profiles Worrisome Market Profiles Chart 35 Worrisome Market Profiles Worrisome Market Profiles Chart 36 Worrisome Market Profiles Worrisome Market Profiles Chart 37 Worrisome Market Profiles Worrisome Market Profiles China’s Liquidity And Credit Cycles Even though China has heightened the pace of monetary easing, it will take several months before its credit impulse rebounds. On average, it takes about six months for reductions in the required reserve ratio (liquidity injections) to produce a meaningful recovery in the credit impulse. So far, the excess reserve ratio has stabilized but not improved. This means the credit impulse will continue stabilizing in the coming months, but a major rise is unlikely in the near term. In turn, the credit cycle leads share prices by several months. All in all, a risk window for China-related plays remains open in the coming months. Chart 38 China's Liquidity And Credit Cycles China's Liquidity And Credit Cycles Chart 39 China's Liquidity And Credit Cycles China's Liquidity And Credit Cycles   Footnotes

HighlightsUpgrade odds of Russia invading Ukraine from 50% to 75%. The US and allies are transferring arms to Ukraine while seeking alternate energy supply for Europe.Of the 75% war risk, we give 10% odds to Russia conquering all of Ukraine, as discussed in our “Five Black Swans For 2022.” Russia’s limited war aims worked in 2014 and President Putin tends to take calculated military risks. Full-scale invasion would force the West to unify.The remaining 25% goes to diplomatic resolution. It appears that the US is not offering Russia sufficient security guarantees. Ukrainian leaders do not have a domestic mandate to surrender and have not done so for eight years. Russia cannot accept the  status quo now that it has made armed demands for big change.Our third key view for 2022 – that oil producing states have geopolitical leverage – is vividly on display.Tactically stay defensive. But cyclically stay invested. Book 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.FeatureUkraine’s economy is small but investors rightly worry that an expansion of the still simmering 2014 war there will cause Europe’s energy supply to tighten, pushing up prices and dragging on European demand. Russia would cut off natural gas to Ukraine, which would cut off 6.6% of Europe’s natural gas imports, 18% of Germany’s, 77% of Hungary’s, and 38% of Italy’s (Chart 1). Chart 1Ukraine Hinges On Germany All Bets Are Off ... Well, Some (A GeoRisk Update) All Bets Are Off ... Well, Some (A GeoRisk Update)  If Europe retaliates against Russia with crippling sanctions, Russia and Belarus could conceivably cut off another 20% of Europe’s imports and 60% of Germany’s imports. The Czech Republic, Finland, and Hungary get almost 100% of their natural gas from Ukraine and Russia, while Finland, Poland, and Hungary get more than half of their oil from Russia. In other words, Europe will try to avoid war and try to limit sanctions so that Russia does not further reduce supply.Yet Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession. The US has already committed to sweeping sanctions against Russia and is much more likely to follow through (though President Biden also wants to avoid an energy shock ahead of midterm elections).Energy consumption amounts to only 2% of European GDP, though it could rise to 5% in the event of a shock, as our European Investment Strategist Mathieu Savary has shown. This number would not be far from the 7% reached in 2008, which coincided with financial crisis and recession. All of Europe will suffer from high prices, not only those that import via Ukraine, and Europe’s supply squeeze would push up global prices as well. So the risk of a recession in Europe will rise if the energy squeeze worsens, even if a recession is ultimately avoided.Whatever Russia ends up doing with its military, it may start off with shock and awe. Europe might see its first major war since World War II. Global investors will react very negatively, at least until they can be assured that the conflict will remain contained in Ukraine. According to our market-based quantitative indicators of Russian geopolitical risk, there is still complacency – the ruble has not fallen as far as one would expect based on key macro variables (Chart 2). Chart 2Russia Geopolitical Risk: Two Quantitative Indicators Russia Geopolitical Risk: Two Quantitative Indicators Russia Geopolitical Risk: Two Quantitative Indicators   Chart 3Russian Market Reaction Amid Ukraine Crisis Russian Market Reaction Amid Ukraine Crisis Russian Market Reaction Amid Ukraine Crisis  Investors will sell European – especially eastern European – equities and currencies even more rapidly if a war breaks out (Chart 3). It is too soon to buy the dip. What is needed is a Russian decision and then clarity on the scope of the western reaction. Even then, developed Europe and non-European emerging markets will be more attractive.Looking at global equities: How did the market respond to previous Russian invasions?Few conclusions can be drawn from Russia’s invasion of Georgia in 2008, given Georgia’s lack of systemic importance and the simultaneous global financial crisis (Chart 4). Stocks underperformed bonds and cyclicals underperformed defensives, but value caught a bid relative to growth.Russia’s initial invasion of Ukraine in 2014 occurred in a different macroeconomic context but saw stocks flat relative to bonds, cyclicals fall relative to defensives (except energy stocks), and small caps roll over relative to large caps (Chart 5). Value stocks, however, outperformed growth stocks. Chart 4Market Reaction To Russian Invasion Of Georgia Market Reaction To Russian Invasion Of Georgia Market Reaction To Russian Invasion Of Georgia ​​​​​  Chart 5Market Reaction To Russian Invasion Of Crimea Market Reaction To Russian Invasion Of Crimea Market Reaction To Russian Invasion Of Crimea ​​​​​  Chart 6Ukraine Crisis And Energy: 2022 Versus 2014 Ukraine Crisis And Energy: 2022 Versus 2014 Ukraine Crisis And Energy: 2022 Versus 2014  However, in today’s context, these cyclical trends are looking stretched, so a temporary pullback from these trends should be expected. Value stocks, especially energy stocks, have skyrocketed relative to growth and defensives and are likely to pull back in a global risk-off move (Chart 6). Tactically we recommend American over European assets, defensives over cyclicals, large caps over small caps, and safe-haven assets like gold and the Japanese yen.Washington Offers “No Change” To MoscowWhy is a diplomatic solution less likely than before?The US offered no concessions to Russia in its formal written response to Russia’s demands on January 26. “No change, and there will be no change” in longstanding policies, according to Secretary of State Antony Blinken.1 The relevant policies are not about NATO membership – Ukraine is never going to join NATO – but rather about the US and NATO making Ukraine a de facto member by providing arms and defense cooperation. Russia obviously sees a US-armed Ukraine as a threat to its national security.One of the few realistic demands of Russia’s – that the US and NATO stop providing arms – has been flung back in Russia’s face. Blinken pointed out in his press conference that the US has given more defense aid to Ukraine in the past year than in any previous year. He said the US will continue to provide arms while pursuing diplomacy, including five MI-17 helicopters on the way. He also noted that the US has authorized allies to transfer American-origin arms to Ukraine.2The importance of the defense cooperation is not the quality of the arms being transferred (so far) but the long-term potential for the US to turn Ukraine into Russia’s Taiwan, i.e. a foreign-backed military enemy on its doorstep. The costs of inaction today could be checkmate from Russia’s long-term strategic point of view. Russia has warned for 14 years that it saw Ukraine as a red line and yet the US and NATO have increased defense cooperation. It is a moot point whether the US provides arms because it does not empathize with Russia’s security interests or because it believes Russia will attack Ukraine regardless.A diplomatic solution could still come from the US, if more information comes to light, or from Ukraine itself, under French and German pressure. Ukraine could make promises to respect Russia’s national security interests and implement the Minsk Protocols it was forced into after Russia seized Crimea in 2014.3If Ukraine surrenders, Russia can claim victory and reduce the threat of war, at least temporarily. But it would not eliminate the long-term risk of war since Ukraine’s government may not be willing or able to implement any such agreement. Ukraine views the Minsk agreement as a Russian imposition and it has rejected key parts of it (such as federalization and granting rights and privileges to Russian separatists in Donbass) for eight years already.4The joint statement from Russia, Ukraine, France, and Germany on January 26 reaffirms the ceasefire in the Donbass.5 It is unlikely that Russia can walk away with this ceasefire alone, having made fundamental demands regarding Russia’s long-term security and the European order. It is more likely that any Ukrainian violation of the ceasefire will now offer a pretext for Russia to respond with military force.Russia’s military advantage is immediate whereas diplomatic attempts by Ukraine to buy time could help it stage a more formidable defense against Russia in future, given ongoing US and NATO defense cooperation. This is why the continuation of arms transfers is the signal. Russia is incentivized to take action sooner rather than later now that the western willingness and urgency to provide arms has increased.Putin has succeeded with his “small war” and “hybrid war” strategy thus far. Russian forex and gold reserves at $630 billion (38% of GDP), gradual diversification away from the dollar (16% of forex reserves), low short-term external debt (5% of GDP), an alternative bank communication system, a special economic relationship with China, a Eurasian Economic Union that can help circumvent sanctions, all provide Russia with some buffer against US sanctions.GeoRisk Indicators: Europe Chart 7European GeoRisk Indicator Amid Ukraine Crisis European GeoRisk Indicator Amid Ukraine Crisis European GeoRisk Indicator Amid Ukraine Crisis  In our Q3 2021 outlook, we argued that European political risk had bottomed due to Russia. Our geopolitical risk indicators show that financial markets tend to price European political risks in line with the USD-EUR exchange rate. The dollar rallied in 2021 and has since fallen back but a war and energy squeeze in Europe should help the dollar stay resilient, as should Federal Reserve rate hikes (Chart 7).If Russia attacks, the Ukrainians will fall back and then mount an insurgency. This will make the war more difficult than its planners initially believe. It will also raise the risk that war will spill over. Neighbors that provide economic aid – not to mention military aid – will eventually make themselves vulnerable to Russian attack, either to destroy commerce or cut insurgency supply lines.NATO will fortify its borders with troops but then tensions will grow on those borders, reducing security and raising uncertainty in the Baltics, Poland, Slovakia, and the Czech Republic. Ukraine could become a war zone like Libya or Syria except that this time the US and Russia would truly be fighting a proxy war against each other.Other European Risks Pale In ComparisonWe will monitor the French election in case the Ukraine conflict causes dynamics to shift against President Emmanuel Macron. Most likely Macron’s diplomatic flourishes, combined with France’s insulation from Russia and Ukraine, will benefit him at the ballot box.In the UK, Prime Minister Boris Johnson faces a leadership challenge. He will probably survive but the Conservative Party faces a serious challenge over the coming years. Labour’s comeback will build ahead of the next election, given that the pandemic has dealt a powerful blow against the Tories, who have been in power since 2010 and are therefore becoming stale. Labour has gotten over the Jeremy Corbyn problem.What matters is whether the UK rejoins the EU, whether Scotland leaves the UK, and whether the next government has a strong majority with which to lead. So far there have not been major changes on these issues:The Tories still have a 75-seat majority through 2024.Support for Scottish independence is stuck at 45% where it has been since 2014.Polling is still evenly divided on Brexit. Labour taking power is a prerequisite to any reunion with the EU, Labour does not want to campaign on re-opening the Brexit issue. While Labour will want to run against inflation, and win back the middle class, rather than for the EU.Thus political risk will be flat, not returning to Brexit highs anytime soon, which is marginally good news for pound sterling over a cyclical horizon (Chart 8). Chart 8UK GeoRisk Indicator And Boris Johnson's Troubles UK GeoRisk Indicator And Boris Johnson's Troubles UK GeoRisk Indicator And Boris Johnson's Troubles  India Enters Populist Phase Of Election Cycle2022 will mark the beginning of India’s election season in full earnest, even though general elections are not due until 2024. This is because within the five-year election cycle spanning from 2019-2024, this year will see elections in some of India’s largest states (Chart 9).More importantly 2022 will see elections take place in most of India’s northern region (Chart 10), which is a key constituency for the ruling Bhartiya Janata Party (BJP). Chart 9India: Major State Elections This Year All Bets Are Off ... Well, Some (A GeoRisk Update) All Bets Are Off ... Well, Some (A GeoRisk Update) ​​​​​  Chart 10North India In Focus With State Elections All Bets Are Off ... Well, Some (A GeoRisk Update) All Bets Are Off ... Well, Some (A GeoRisk Update) ​​​​​ Of all the state elections due this year, the most critical will be those in Uttar Pradesh, where voting will begin on February 10, 2022. Final results will be declared a month later on March 10, 2022.Uttar Pradesh Will Disappoint BJPAt the last state elections held in Uttar Pradesh in 2017, BJP stormed into power with one of the strongest mandates ever seen in this sprawling and heterogenous state. The BJP boosted its seat share to an extraordinary 77%, leaving competitors far behind (Chart 11). Chart 11Bhartiya Janata Party (BJP) Stormed Into Power In Uttar Pradesh (UP) In 2017 All Bets Are Off ... Well, Some (A GeoRisk Update) All Bets Are Off ... Well, Some (A GeoRisk Update)  Cut to 2022, the BJP appears likely to cross the 50% majority threshold but will cede seat share to a regional party called the Samajwadi Party (SP).What will drive this reduction in seats? The reduction will be driven by a degree of anti-incumbency sentiment and some adverse socio-political arithmetic. In a state where voting is still driven to a large extent by identity politics, it is worth recalling that the BJP was able to win the 2017 elections by pulling votes from three distinct communities:BJP’s core constituency of upper caste Hindus.A subset of Other Backward Classes (OBCs).A subset of a community belonging historically to one of the lowest social levels in India called Dalits.This winning formula of 2017 may not work in 2022 as the BJP faces resentment from parts of each of these three communities as well as from farmers (who were against farm law reforms that the BJP tried to pass).There is a chance that these groups may flock to the regional Samajwadi Party in 2022. The latter is in a position of strength as it is expected to retain support from its core constituency of Muslims and upper-caste OBCs too.Yet the risk is to the downside for the ruling party. Modi and the BJP have suffered a hit to their popular support from the global pandemic and recession, like other world leaders.Reading The Tea Leaves For 2024The pro-Modi wave that began in 2014, and gained steam in Uttar Pradesh in 2017, became a tsunami by 2019, causing the BJP to win a decisive 56% of seats in the national assembly. So, if the BJP loses seats in Uttar Pradesh this year, what will be the implications for the general elections of 2024?In a base case scenario, the Modi-led BJP appears set to emerge as the single largest party in the 2024 elections (albeit with a lower seat share than the 62 of 80 seats that the BJP managed in 2019). As the BJP administration ages, it is expected to lose a degree of seat share in its core constituency of north India. But these losses should be partially offset by gains in regions like east India where the BJP continues to make inroads. Also, national parties tend to attract higher vote share at general elections as compared to state elections, and this is true for the BJP. Most likely the pandemic will have fallen away by 2024 and the economy will be expanding.However, a lot can change in two years, and a major disappointment at Uttar Pradesh would sound alarm bells. By 2024, the BJP will have been in power for ten years. So it is not a foregone conclusion that the BJP will win a single-party majority for a third time, even if it does remain the biggest party.Regional parties like the Samajwadi Party (from Uttar Pradesh), Trinamool Congress (from West Bengal), Shiv Sena (from Maharashtra) and Aam Aadmi Party (from New Delhi) are small but rising and may incrementally eat into the BJP’s national seat share.Policy Implications For 2022 Chart 12India’s Fiscal Report Card May Worsen With Populism All Bets Are Off ... Well, Some (A GeoRisk Update) All Bets Are Off ... Well, Some (A GeoRisk Update)  India’s central government will unveil its budget for FY23 on Feb 1, 2022 in the Indian parliament. We expect the government to announce a fiscal deficit of 6.6% of GDP which will be marginally lower than the FY22 target of 6.8% of GDP. However, with key elections around the corner, we allocate a high probability to the government announcing a big-bang pro-farmer or pro-poor scheme from this pulpit. This high focus on populism and inadequate focus on capital expenditure could lead markets to question India’s fiscal well-being at a time when its debt levels are high (Chart 12).Distinct from policy risks in the short run, geopolitical risks confronting India are elevated too. India’s relationship with China continues to fester. Sino-Indian frictions could easily take a turn for the worst in 2022 as India enters the business end of its five-year election cycle on one hand and China’s all-important 20th National Congress of the Chinese Communist Party (NCCCP) is due in the fall of 2022. China could take advantage of US distraction in Ukraine to flex its muscles in Asia. A geopolitical showdown with China would likely only cause a temporary drop in Indian equities, but taken with other factors, now is not the time to buy.Bottom Line: We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India.GeoRisk Indicators: Rest Of WorldNeutral China: China’s performance relative to emerging markets may be starting to bottom but we do not recommend buying it. Domestic political risk is still rising according to our indicator and we expect it to keep rising (Chart 13). Negative political surprises will occur in the lead up to the twentieth national party congress and the March 2023 implementation of the “Common Prosperity” plan. Any Russian conflict will distract the US and enable General Secretary Xi Jinping to cement his second ten-year term in office – and China’s reversion to autocracy – with minimal foreign opposition. The US’s conflict with China is one reason Russia believes it has a window of opportunity. Chart 13CHINA GEORISK INDICATOR CHINA GEORISK INDICATOR CHINA GEORISK INDICATOR  Short Taiwan: Taiwan’s geopolitical risk has paused far short of previous peaks as the country’s currency and stock market benefit from the ongoing semiconductor shortage. But a peak may be starting to form in relative equity performance (Chart 14). We doubt that China will see any Russian attack on Ukraine in 2022 as an opportunity to invade Taiwan, although economic sanctions and cyber-attacks are an option that we fully anticipate. Invading Taiwan is far more difficult militarily than invading Ukraine and China is less ready than Russia for such an operation. However, China might be able to exploit a Russian attack as soon as 2024. Chart 14TAIWAN TERRITORY GEORISK INDICATOR TAIWAN TERRITORY GEORISK INDICATOR TAIWAN TERRITORY GEORISK INDICATOR  Long South Korea: South Korea’s presidential election is approaching on March 9 and this event combined with North Korea’s new cycle of missile provocations will keep political risk elevated (Chart 15). The conservative People Power party has pulled ahead in opinion polling and the incumbent Democratic Party has been weakened by the pandemic. But the race is still fairly tight and a viable third party candidate could make a comeback. China’s policy easing should eventually benefit South Korea. Chart 15SOUTH KOREA GEORISK INDICATOR SOUTH KOREA GEORISK INDICATOR SOUTH KOREA GEORISK INDICATOR  Long Australia: Australia’s federal election must be held by May 21 and anti-incumbency feeling has taken hold, with the Liberal-National coalition collapsing in opinion polls relative to the Australian Labor Party. Australia still faces shockwaves from the pandemic and China’s secular slowdown, reversion to autocracy, and conflict with the US, especially if the US gets distracted in Europe. Political risk is high and rising (Chart 16). However, Australia benefits from rising commodity prices and we favor developed markets outside the United States. Chart 16AUSTRALIA GEORISK INDICATOR AUSTRALIA GEORISK INDICATOR AUSTRALIA GEORISK INDICATOR  Long Canada: Canada’s recapitalized its political system with last year’s general election and political risk is subsiding (Chart 17). Canada benefits from rising oil and commodity prices and close proximity to the hyper-stimulated US economy. Chart 17CANADA GEORISK INDICATOR CANADA GEORISK INDICATOR CANADA GEORISK INDICATOR  Neutral Turkey: Turkey is one of our perennial candidates for a “black swan” event as the country’s political stability continues to suffer under strongman rule, unorthodox monetary and fiscal policy, military adventures in North Africa and Syria, and now a Russian bid to dominate the Black Sea. Elections looming in 2023 will provoke turmoil as the Erdogan administration is extremely vulnerable and yet has many ways to try to cling to power (Chart 18). Chart 18TURKEY GEORISK INDICATOR TURKEY GEORISK INDICATOR TURKEY GEORISK INDICATOR  Neutral Brazil: Brazilian political risk is subsiding as the market expects former President Lula da Silva to return to power in this October’s presidential election and replace current populist President Jair Bolsonaro. Relative equity performance always appears as if it has bottomed only to inch lower in the next selloff. China’s policy easing is a boon for Brazil but China is not providing massive stimulus, the election will be tumultuous, and even a Lula victory will need to see a market riot to ensure that structural reforms are pursued (Chart 19). Chart 19BRAZIL GEORISK INDICATOR BRAZIL GEORISK INDICATOR BRAZIL GEORISK INDICATOR  Long South Africa: South Africa still faces elevated political risk despite the conclusion of the 2021 municipal elections. However, the ruling African National Congress, which is pursuing an anti-corruption drive, is likely to stay in power, lending policy continuity. Equities have bottomed and are rebounding relative to emerging markets (Chart 20). The danger is that structural reforms will slip ahead of the spring 2024 election. Chart 20SOUTH AFRICA GEORISK INDICATOR SOUTH AFRICA GEORISK INDICATOR SOUTH AFRICA GEORISK INDICATOR  Investment TakeawaysTactically stay long gold, defensives over cyclicals, large caps over small caps, Japanese industrials versus German, GBP-CZK, and JPY-KRW.Book a 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.   Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Ritika Mankar, CFAEditor/Strategistritika.mankar@bcaresearch.comFootnotes1      For Blinken’s press conference on the US formal response to Russia, see US Department of State, "Secretary Antony J. Blinken at a Press Availability," January 26, 2022, state.gov.2     For Ukraine’s criticism that Germany should offer pillows in addition to helmets, see Humeyra Pamuk and Dmitry Antonov, "U.S. responds to Russia security demands as Ukraine tensions mount," Reuters, January 26, 2022, reuters.com. For the US’s $2.5 billion in defense aid to Ukraine since 2014, see Elias Yousif, "U.S. Military Assistance to Ukraine," January 26, 2022, stimson.org. For purpose and significance, see Samuel Charap and Scott Boston, "U.S. Military Aid to Ukraine: A Silver Bullet?" Rand Blog, rand.org.3     Michael Kofman, "Putin’s Wager in Russia’s Standoff with the West," War on the Rocks, January 24, 2022, warontherocks.com.4     In 2021 the US apparently moved to embrace the Minsk Protocols for the first time, but since then it has not joined the talks. See National Security Adviser Jack Sullivan, "White House Daily Briefing," December 7, 2021, c-span.org. 5             Élysée, "Declaration of the advisors to the N4 Heads of States and Governments," January 26, 2022, elysee.fr. See also "Russia, Ukraine agree to uphold cease-fire in Normandy talks," DW, January 26, 2022, dw.com.Geopolitical CalendarStrategic ThemesOpen Tactical Positions (0-6 Months)Open Cyclical Recommendations (6-18 Months)

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? ...Could The Same Happen To US Stocks? ...Could The Same Happen To US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse CAD/SEK Could Reverse CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Feature Chart 1Weak Economic Fundamentals Undermine Stock Performance Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Monetary policy easing has intensified in the past two months. The PBoC reduced one-year loan prime rate (LPR) by 10 bps and five-year by 5 bps following last week’s 10bps cut in policy rates1 and December’s 50 bps drop in the reserve requirement rate (RRR). Nonetheless, the onshore financial market’s response to the monetary policy actions has been muted. China’s A-share market price index fell by 3% in the past month. Credit growth has bottomed, but there is no sign of a strong rebound despite recent rate decreases (Chart 1, top panel). The impaired monetary policy transmission mechanism will likely delay China’s economic recovery, which normally lags the credit cycle by six to nine months. Moreover, the marginal propensity to spend among both corporates and households continues to decline, highlighting a lack of confidence among real economy participants, and will in turn dampen the positive effects of policy stimulus (Chart 2).  The poor performance of Chinese onshore stocks (in absolute terms) is due to a muted improvement in credit growth and deteriorating economic fundamentals (Chart 1, bottom panel). Our model shows that China’s corporate profits are set to contract in next six months, implying that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive (Chart 3). Therefore, investors should maintain an underweight allocation to Chinese equities for the time being. Chart 2Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Chart 3China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Improving Liquidity, Weakening Credit Demand The modest uptick in December’s total social financing (TSF) growth largely reflects a significant increase in government bond issuance, while bank loan growth continued on a downward trend (Chart 4). Corporate loan demand remained sluggish, which dragged down aggregate bank credit growth (Chart 5). Downbeat business confidence suggests that corporate demand for credit will take longer to turn around, and therefore will reduce the effectiveness of current easing measures. Chart 4Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Chart 5Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Meanwhile, corporate bill financing has risen rapidly in recent months and now accounts for almost 40% of new bank loans, the highest level since 2010 (Chart 5, bottom panel). The high share of short-term lending to the corporate sector highlights the underlying weakness in both loan supply and demand.  Banks are risk averse and reluctant to approve longer-term credit to the corporate sector, while corporates are unwilling to take on more debt.  As a result, banks have had to issue short-term bills in order to meet their lending quota. Proactive Fiscal Policy Will Have A Limited Impact On Infrastructure Investments Chart 6Local Government SPBs Will Be Frontloaded In 2022 Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Fiscal policy will likely be frontloaded in Q1 this year, but the impact of a proactive fiscal policy on boosting infrastructural investment may be limited. According to a statement by the Ministry of Finance last December, around RMB1.46 trillion in the quota for local government special purpose bonds (SPBs) has been frontloaded for 2022. If we assume that all of the SPBs will be issued in Q1, the amount will be higher than SPBs issued during the same period in 2019, 2020 and 2021 (Chart 6). We expect a total SPBs quota of RMB 3.5 trillion for 2022, roughly the same as 2021.  This implies a zero fiscal impulse on SPBs in 2022 compared with 2021. However, there were an estimated 1.2 trillion in SPB proceeds in 2021 that local governments failed to invest and this amount could be deployed in 2022. If we add last year’s SPB carryover to this year’s quota, there may be a 30% increase in the available funds to invest in infrastructure projects in 2022. Chart 7Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending However, a 30% jump in SPB proceeds does not suggest an equal boost in infrastructure spending this year (Chart 7). As noted in previous reports, SPBs issued by local governments only account for around 15% of total funding for infrastructure spending. Bank loans, which remain in the doldrums, are a much more significant driver in supporting the sector’s investment.  Secondly, infrastructure spending has structurally downshifted since 2017 due to a sweeping financial deleveraging campaign to rein in shadow banking activity by local government financing vehicles (LGFVs). Shadow banking activity, which is highly correlated with infrastructure investment growth, is stuck in a deep contraction with no signs of an imminent turnaround (Chart 7, bottom panel). Thirdly, land sales play a prominent role in local government financing, accounting for more than 40% of local government aggregate revenues2 compared with about 15% from SPBs (Chart 8). Local government fiscal spending power will be constrained due to a significant and ongoing slowdown in land sales and regulatory pressures on LGFVs (Chart 8, bottom panel).    Therefore, we expect that infrastructure spending will only moderately rebound in 2022. At best, it will return to its pre-pandemic rate of around 4% (year-over-year) in 2022 (Chart 9, top panel). Notably, onshore infrastructure stocks have priced in the recent favorable news about proactive fiscal policy support in 2022 (Chart 9, bottom panel). Given that infrastructure investment will likely only improve modestly this year, on a cyclical basis the sector’s stock performance upside will be capped and renewed weakness is likely. Chart 8Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Chart 9Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate More Policy Fine-Tuning Is Underway, But Housing Policy Reversal Remains Doubtful Last week’s 5bp reduction in the 5-year LPR, which serves as a benchmark for mortgage loans, was positive for the housing market. However, the cut is insufficient to revive the demand for housing. Moreover, the asymmetrical rate reductions - a 10bps drop in the 1-year LPR versus a 5bps reduction in the 5-year - signals that the authorities are reluctant to decisively reverse housing policies. Sentiment in the housing sector remains downbeat. A survey conducted by the PBoC shows that the willingness to buy a home has plunged to the lowest level since 2017 (Chart 10). Medium- to long-term household loan growth, which is highly correlated with home sales, decelerated further in December (Chart 10, bottom panel). Given that home prices continue to decline, buyers may be expecting more price discounts and refrain from making purchases despite slightly cheaper mortgage rates. Although there was a modest pickup in medium- to long-term consumer loan growth in November, it was mainly driven by pent-up mortgage applications delayed by the banks in Q3. Moreover, advance payments for real estate developers remained in contraction through end-2021. The prolonged weakness in the demand for mortgages and homes highlights our view that it will take more than a minor mortgage rate cut to revive sentiment (Chart 11). Chart 10Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Chart 11Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Without a decisive improvement in home sales, real estate developers will continue to face funding constraints, which will weigh on new investment and housing projects (Chart 12). We expect the contraction in real estate investment and housing starts to be sustained through at least 1H22 (Chart 13). Chart 12Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Chart 13Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Chinese Export Growth Will Converge To Long-Term Growth Chart 14Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 China’s exports grew vigorously in 2021, providing critical support to the economy.  Net exports contributed 1.7 percentage points to the 8.1% rate of real GDP growth in 2021, the highest growth contribution since 2006. China’s share of global exports expanded to more than 15%, about 2 percentage points higher than the pre-pandemic average from 2015 to 2019 (Chart 14). The export sector probably will not repeat last year’s strong performance. The widening divergence of exports in value and in volume suggests that the solid aggregate value of exports has been mainly buttressed by soaring export prices since July 2021 (Chart 15). The price effect will likely gradually abate in 2022 due to easing global supply chain constraints, softer global economic growth and a high base factor from 2021. Indeed, export prices from China and other industrialized countries may have already peaked (Chart 16). Chart 15Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Chart 16Export Prices May Have Peaked Export Prices May Have Peaked Export Prices May Have Peaked Services spending worldwide will likely normalize and lead global demand growth in 2022. Meanwhile, goods spending will moderate, implying weaker demand for China’s manufactured goods (Chart 17). Furthermore, China’s strong exports to emerging markets (EM) since Q2 2021 reflected supply shortages due to production interruptions in the EMs (Chart 18). We expect supply chain disruptions in these economies to ease in 2H22 when Omicron-induced infections subside and antiviral treatments become available worldwide. As such, China’s exports to those regions may gradually return to pre-pandemic levels. Chart 17US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 Chart 18Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 China’s manufacturing utilization capacity reached a historical high in 2021, supported by hardy external demand for goods. However, profit margins in the manufacturing sector have been squeezed due to surging input costs (Chart 19). Manufacturing investment growth has been falling, reflecting the reluctance by manufacturers to expand their business operations amid narrowing profit margins (Chart 20). The profit outlook for the manufacturing sector will be at risk of deterioration when the growth in both export volumes and prices moderate in 2022.  Chart 19Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Chart 20Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Rising Import Prices Mask The Weakness In Chinese Domestic Demand Chinese import growth in value remained resilient through December, but has increasingly been driven by rising import prices. Import growth in volume, which is a truer picture of China’s domestic demand, decelerated at a faster rate in 2H21 (Chart 21). Credit impulse, which normally leads import growth by around six months, only ticked up slightly. The minor improvement in the rate of Chinese credit expansion will provide limited support to the country’s imports in 1H 2022 (Chart 22).  Chart 21Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand   Chart 22Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Chart 23Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints The volume of Chinese-imported key commodities, such as iron ore and steel, rebounded in the past three months, but its growth remains in contraction on a year-on-year basis (Chart 23). The improvement in Chinese commodity imports, in our view, reflects an easing in production constraints rather than escalating demand. Recently released economic data, ranging from manufacturing PMI, industrial production, fixed-asset investment and construction activity, all point to an imbalanced supply-demand picture in China’s economy (discussed in the next section).    Sluggish Quarterly Economic Growth At End Of 2021 China’s economy expanded by 8.1% in 2021 or at a 5.1% average annual rate in the past two years.  However, quarterly GDP growth on a year-over-year basis slowed further to 4% in Q4 from 4.9% in the previous quarter. On a sequential basis, seasonally adjusted GDP growth in Q4 was 1.6 percentage points above that of Q3, but slightly below its historical mean (Chart 24). Chart 24Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Chart 25Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Chart 26Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Although industrial production accelerated somewhat in December, it reflects a catch-up phase following a period of constrained output amid last fall’s energy crisis (Chart 25). On the other hand, lackluster domestic demand and a further slowdown in the housing market significantly dragged down China’s economic expansion in Q4. Both fixed-asset investment and consumption decelerated significantly in 2021 Q4, more than offsetting an improvement in net exports (Chart 26, top panel). Notably, year-over-year growth rates in construction and real estate components of real GDP fell below zero in Q4 (Chart 26, bottom panel). In light of the subdued credit growth through end-2021, China’s economic activity will not regain its footing until mid-2022.  Slow Recovery In Household Consumption Likely Through 1H22 The household consumption recovery was sluggish in 2021 and it will face strong headwinds at least through 1H22. China’s consumption recovery has been hindered by a worsening labor market situation, depressed household sentiment and renewed threats from flareups in domestic COVID-19 cases. China’s labor market situation shows a mixed picture. The urban unemployment rate has dropped to pre-pandemic levels and stabilized at 5.1% in December. It remains well within the government’s 2021 unemployment target of “around 5.5%”. However, urban new job creations plunged sharply and the number of migrant workers returning to the cities remains far below the pre-pandemic trend (Chart 27). China’s imbalanced economic recovery in the past two years led to a substantially slower pace of job creation in labor-intensive service sectors (Chart 28). Moreover, wages have been cut and the unemployment rate among younger workers have climbed rapidly in sectors suffering from last year’s regulatory crackdowns in real estate, education and internet platforms. Even though policies have recently eased at margin, it will take time for labor market dynamics (a lagging indicator) to improve. Chart 27Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening Chart 28Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Chinese household expenditures have lagged disposable incomes since the outbreak of the pandemic (Chart 29). The propensity to consume has declined since 2018 and the downward trend has been exacerbated by the pandemic since early 2020 along with a soaring preference to save (Chart 30). Chart 29Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chart 30Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Household consumption also faces renewed threats from increases in domestic COVID-19 cases. Since Q3 last year, more frequent city-wide lockdowns and inter-regional travel bans have had profound negative effects on the country’s service sector and retail sales (Chart 31 & 32). Omicron has also spread to China, triggering new waves of stringent countermeasures. China will not abandon its zero-tolerance policy towards COVID anytime soon, thus we expect the stop-and-go economic reopening to continue to weigh on the country’s service sector activity and consumption at least through 1H22. Chart 32Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Chart 31China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022   Table 1China Macro Data Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Table 2China Financial Market Performance Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand   Footnotes 1     The 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rates. 2     Including local government budgetary and managed funds revenues.   Strategic View Cyclical Recommendations Tactical Recommendations